Inflation destroys purchasing power is a well-known fact. A doughnut that costs $1 today adjusted for 5% inflation will cost $2 in 10 years. Just to keep up one’s lifestyle, one’s income must double in ten years, a tall task. A school of thought exists around paying down one’s home mortgage, playing on emotions rather than grounded in financial literacy.
Benefits of maintaining home mortgage
a) Hedge against inflation
b) Protection against litigation
c) Interest deduction against income.
d) Opportunity cost
This article explains how not paying down your mortgage serves as a hedge against inflation. I will explain this with a couple of scenarios.
Scenario 1: One buys a house for $100,000 in cash. The cost of one doughnut is $1. Assume the inflation is 5%, in 10 years the doughnut will cost $2, and the house will be worth $200,000.
Today
Price of House $100,000
Cash Invested $100,000
Price of Doughnut $1
Number of Doughnuts you can buy 100,000
In 10 years
Price of House $200,000
Cash Available $200,000
Price of Doughnut $2
Number of Doughnuts you can buy 100,000
Purchasing power has remained the same despite the fact the investment value has doubled.
Scenario 2: One buys a $100,000 house but with 50% down payment. Assume it is interest only loan.
Today
Price of House $100,000
Cash Invested $50,000
Price of Doughnut $1
Number of Doughnuts you can buy 50,000
In 10 years
Price of House $200,000
Loan Payoff $50,000
Cash Available $150,000
Price of Doughnut $2
Number of Doughnuts you can buy 75,000
Purchasing power has increased by 50%.
Conclusion: Mortgage passes on the risk of inflation to the lender. With the same kind of returns, purchasing power of a person who is maintaining debt (mortgage) is 1.5 times higher than the person paying cash or accelerating pay down of mortgage. Houses are usually bought with 20% down payment, in this example, with the same $100,000, one can buy five houses and exponentially increase the purchasing power.
For more information on how you can accelerate your purchasing power, get in touch with inder@insimproperties.com.